Answer to Question #139410 in Macroeconomics for Bipul kumar

Question

Suppose you are the manager of a chain of computer stores. You closely follow the computer industry and you have just learnt that the government has passed a two-pronged program designed to enhance the country’s computer industry’s position in the global economy. The legislation provides increased funding for computer education in primary and secondary schools, as well as tax breaks for firms that develop computer software. As a result of the legislation, what do you predict will happen to the equilibrium price and quantity of software? Explain in detail with diagrams bringing out the difference between change in quantity demanded and change in demand.

Answer 1

Effects of the Legislation.

Equilibrium quantity will increase.

Equilibrium price will be indeterminate.

Explanations.

Increased funding for computer education in primary and secondary schools will increase disposable income of the buyers (schools). Assuming computers are normal goods, the increase in disposable income will provoke an increase in computer demand. Now, because computers and softwares are normal goods, the demand of softwares also increases, exerting an upward pressure on price and quantity demanded, assuming that the demand for computer software is fairly elastic.

On the contrary, tax breaks to firms that produce computer software will reduce the cost of software production. Now, because cost of production is a major supply determinant, the supply of software will increase thereby exerting a downward pressure on prices, assuming that supply for computer software is relatively elastic, and a further increase in quantity demanded.

The diagram below illustrates how the computer software industry responds to the government legislation.

The diagram assumes that both demand and supply of computer software are relatively elastic, and that computer software is a normal good. As shown on the diagram, the market is initially in equilibrium at point e1, where initial demand curve D1 and the initial supply curve S1 interact. An increase in government funding for computers increased disposable income thereby pushing the demand for computers upwards, which resulted in an increase in the demand for the complementary good - computer software. As shown on the graph, the demand for computer software swivels from D1 to D2, followed by an increase in both output and price.

More so, the supply curve increased from S1 to S2 in response to decrease in the cost of production as tax breaks are effected. The increase in supply, as shown, increased supply but exerted a downward momentum on prices.

Eventually, the market establishes a new equilibrium at point e2, where demand curve D2 and supply S2 interact. The equilibrium quantity increased from Q1 to Q2 and price drops from P1 to P2. However, price is indeterminate since since it dependents on the magnitudes of movements of demand and supply. Therefore, price can increase, decrease, or remain unchanged.